General thoughts of market

True value investors see the stock market as a giant yard sale, at times there’s a fire garage sales going on, at times, the market is so fully or overly priced with the exception of one or two available at a humble discount. Prior to late last year, there were occasionally a few penny stocks on SGX that happen to be overlooked treasures. By today, even the last one that is extremely undervalued (based on the Graham method of valuation) a month back is gone – that was Lion Asia Pac, about a month back it was available at 17 cents and cash alone was covering its share price, yes, you heard that right. But such dusty diamonds are hardly, if even available today, are a lot harder to find now. It seems to be a generally fully-priced, or even overly, world out there. Perhaps this is because of the world is awash with cash. This is partly because of the low return rates otherwise provided by the banks. With the market as buoyant as it is right now, it turns out to be on the surface a no-brainer that putting money in the stock market would beat the return otherwise held in the bank. But with too much cash chasing too few assets, all stocks, good or bad, are pushed to a yet higher level without consideration for the risk involved.

With stock market prices going up, and yet even more cash available, the additional liquidity brings additional buyers, and some of the excess flows to other investment type of assets like properties, arts, and even ships and aeroplanes.

But fortunately, the world is connected and since the stock market is a giant yard, it covers the whole world of public companies. In the U.S., there are specifically a few large-cap, high quality companies that a value investor can gain an edge – like McDonald, Wal-Mart, P&G, Johnson & Johnson.

In addition, of all the big companies in the whole world, the most misunderstood and probably mispriced one is likely to be Berkshire Hathaway. Because of its large, complex, multi-businesses of which many has no synergy, offers no earnings guidance, has little Wall Street following, and once a year, you get to come to Omaha and get in line with everyone else to gain the same advantage by listening to the business progress, it seems hard to thus put a value to its business especially with no “professional” help from Wall Street.

Although many Wall Street analysts find it tough to put a value to its stock, the Berkshire’s annual report apparently makes that task simple and transparent enough. Each group of her business and some individually, are given with the essential information to put a decent valuation to each individual group of business.

If the world has run out of any undervalued stock, and even if Berkshire is fully-priced, or slightly over-priced, I would trust it into Berkshire as it is the safest stock that is sure to appreciate as time goes by with its quality stable of equities and businesses.

Dividend Policy

When it comes to dividend policy, it is seldom explained on the logic. A company will say, “Our goal is to pay out 40% of earnings and to increase dividends at a rate at least equal to the rise in the CPI” and that’s it. There’s no explanation or analysis as to why that particular dividend policy is best for the owners of the business. Yet, allocation of capital is crucial to the business and investment management. Thus, it is important for both owners and managers to think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses, particularly those that have high asset to profit ratios, inflation causes some or all of the reported earnings to become unreal. The unreal portion – otherwise known as “restricted” – cannot be distributed as dividends if the business is to retain its economic position. Were these earnings to be distributed, the business would lose ground in one or more of the following areas: 1) its long-term competitive position, 2) its ability to maintain its unit volume of sales, 3) its financial strength. No matter how conservative its payout ratio, a business that consistently distributes restricted earnings is destined for oblivion unless equity capital is injected.

Restricted earnings are seldom valueless to owners, however, they must be heavily discounted. In effect, it is conscripted by the business, regardless how poor its economic potential. This retention-no-matter-how-unattractive-the-return situation is reflected in many so-called undervalued stocks that are selling well below its book value. For instance, A is selling for as low as one third its book value because of its economic reality. Every time, a dollar of earnings retained for reinvestment in the business, that dollar is transformed into only 25 cents of market value. But despite this gold-turn-into-lead process, most earnings were reinvested in the business rather than paid to owners. But this is inevitable as long as the business wants to survive in the industry.

Now, let’s turn our attention to the much more valuable unrestricted portion of the earnings. These earnings may, with equal probability, be retained or distributed. Management should chose the course that makes the greater sense for the owners of the business.

This principle is not universally or commonly accepted and practiced. For a variety of reasons managers like to withhold unrestricted earnings from shareholders. This may be to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, to enhance the value of his share options, etc. But in the view of the shareholders, there’s only one valid reason for retention. Unrestricted earnings should be retained only when there’s a reasonable prospect that for every dollar retained by the business, at least one dollar of market value must be created for the owners. This will only happen only if the capital retained produces incremental earnings equal to or more than those generally available to shareholders.

To illustrate, let’s assume an investor owns a risk-free 10% perpetual bond with one very unique feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e. a perpetual life and coupons offering the same cash or reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting his cash should instead take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.

If, however, if interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were zero. The opposite course – reinvestment of the coupon – would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they’ll be available at a large discount.

An analysis similar to that made by the hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or distributed. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond example, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them to paid to you if low returns are the likely outcome of reinvestment.

Many corporate managers reason very much along these lines in determining whether their subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level are often a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.

Following this approach, the CEO of a conglomerate will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO will accept no lesser behavior and will have no problem following through on this in his parent-subsidiary relationship. But if his own long-term record with incremental capital is 5% and the market rates are 15%, he’s likely to impose a dividend policy on the shareholders of the parent company that simply follows some historical or industry-wide payout pattern. Moreover, he’ll expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But ironically, he will seldom supply his owners with a similar analysis pertaining to the parent company.

When judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total increment capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of its excess cash in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns beings earned by the portion of earnings incrementally invested in the core business. The situation is similar to a basketball game: even if 11 of the 12 players are hopeless scorers, the team’s best scorer will be respectable because of the dominating skills of the star player.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. But most times, they don’t.

In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in sub-par businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held responsible for those allocation decisions, regardless of how profitable the overall enterprise is.

Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, thus, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distribution earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.

We know excellent businesses throw off a lot of excess cash and somehow this excess cash must either be put to good use or to distribute back to owners. By distributing to owners, there’re two ways – by dividend or stock repurchase. However, what is more important is how management put the excess cash to good use through purchase of new businesses.

To illustrate, Conglomerate A owns many subsidiaries of which B is one of those. In 2006, B earned $72 million pre-tax compared to $8 million pre-tax when A acquired B 15 years ago. While an increase from $8 million to $72 million sounds terrific – and usually is – one should not automatically quantify that to be the case. You must firstly ensure that earnings in the base year were not severely depressed. If they were instead substantial in relation to capital employed, an even more critical issue must be examined: how much additional capital was required to produce the additional earnings. If a dollar of additional capital produces a dollar of earnings, it is no great feat – putting in a saving account will produce the same desired result.

In our case, B did exceptional well in both respects. First, the earnings 15 years back were excellent compared in relation to capital then employed in the business – earning $8 million on $40 million of tangible assets. Second, although annual earnings are now $64 million greater, the business requires only $40 million more in invested capital to operate than was the case then.

The dramatic growth in earning power of B, accompanied by their minor need for incremental nominal capital, illustrates clearly the power of the economic goodwill during an inflationary period (a phenomenon as detailed in the article before this). The financial characteristics of B have allowed A to use a very large portion of the earnings B generate elsewhere – acquiring C, D and so on. If an average business requires $8 million to generate an additional $1 million in pre-tax earnings, that business would, therefore, have needed over $550 million in additional capital from its owners in order to achieve an earnings performance commensurate to our fictitious business B.

When returns on capital are ordinary, an earn-more-by-putting-up-more strategy is no great managerial feat. You can get the same result personally while operating from your rocking chair – just triple your principle in a savings account and you tripled your earnings. If you know the facts, you would have held back praises for such actions. Yet, when CEOs retire, praises were often heaped for even those who quadrupled earnings in such companies during their reign – with no one examining whether this gain was attributable to many years of retained earnings and the working of compound interest.

If the company consistently earned a superior return on capital throughout the period, or if capital employed only doubled while earnings quadrupled during the CEO’s reign, the praise may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be restrained. A savings account in which interest at 8% would quadrupled in earnings in 18 years (of course, savings account isn’t 8% now).

The power of this simple math is often ignored by companies to the detrimental of their shareholders. Many corporate compensation plans reward managers handsomely for earnings increases produced sorely, or in large part, by retained earnings (earnings withheld from owners). For instance, 10-year, fixed-priced stock options are granted routinely, often by companies whose dividends are only a small percentage of earnings.

An illustration will show the inequities possible under such circumstances. Let’s suppose you had a $100,000 savings account earning 8% interest and “managed” by a trustee who could decide each year what portion of the interest you were to be paid in cash. Interest not paid would be “retained” and added to the savings account to compound. And let’s suppose that your trustee, in his superior wisdom, set the “pay-out ratio” at one quarter of the annual earnings.

Under these terms, your account would be worth $179,084 at the end of ten years. Additionally, your annual earnings would have increased about 70% from $8,000 to $13,515 under this “inspired” management. And, at last, your “dividends” would have increased commensurately, rising regularly from $2,000 in the first year to $3,378 in the tenth year. Each year, when your manager prepared his annual report to you, all of the charts would have had lines marching skyward.

Now to add more fun, let’s push the scenario one notch further and give your trustee-manager a ten-year fixed-priced option on part of your “business” (i.e. your savings account) based on its fair value in the first year. With such an option, your manager would reap a substantial profit at your expense – simply by withholding most of your earnings. If he was both a Machiavellian and a bit of a mathematician, he might just cut the payout ratio totally once he was firmly entrenched.

This scenario is not as far fetched as you might think. Many stock options in the corporate world simply have worked in the exact same way. They have gained in value simply by withholding earnings and not because it did well with the capital in its hands. If granting stock options as a way of compensation to its executives is a way of wresting shareholder’s funds, it will be even more unthinkable for those businesses where its managers grant options that was still regularly adding or obtaining additional capital for the business.

You would hardly see anywhere in the business world where ten-year options are granted to outsiders – ten-months are in fact very rare. The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period. Managers regularly engineer ten-year, fixed-priced options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value, and second, ignore the carrying cost of capital. As such, these managers end up profiting much as they would have had they had an option on that savings account that was automatically building up in value.

Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. Ironically, managers who are really exceptional to shareholders almost always get far less than they should. But when the result is equitable, it is accidental. Once granted, the option is blind to individual performance. Because it is irrevocable and unconditional (as long as the manager remains in the company), the sluggard receives rewards from his options precisely as does the star.

Ironically, the oratory about options frequently describes it to be desirable because they put managers and owners in the same financial situation. In reality, the situations are far apart. In terms of capital costs, owners have bore the burden of it whereas the holder of a fixed-priced option bears no capital costs at all. An option holder has no downside risk while the owners have to weigh the upside potential against the downside risk. In fact, the business project in which you would wish to have an option is frequently the project in which you would reject ownership – you’ll be happy to accept a TOTO ticket as a gift but you’ll never buy one.

Despite the shortcomings of options, it can be appropriate under certain circumstances. The earlier criticism on it relates to its indiscriminate use and, in this connection, there are a couple of points that need to be highlighted.

First, stock options are inevitably tied to the overall corporation performance. Thus, it should logically be awarded only to those managers with overall responsibility that causes the eventual result within their scope. The Michael Jordan of a team should expect, and also deserve, a big payoff for his performance – even if he plays for a mediocre team. While the side-kicks should get rewards that fit their performance even if he plays for a perennial winning team. Only those with overall responsibility for the team should have their rewards tied to its results.

Second, options must be structured carefully. There should be a carrying-cost factor built into it. Equally important, they should be priced realistically. Managers unfailingly point out how unrealistic market prices can be as an index of real value when they are faced with offers for their companies. But why, then, should these same depressed prices be the valuations at which managers sell portions of their businesses to themselves? Owners are generally not well served by the sale of part of their business at a bargain price – whether the sale is to outsiders or insiders. Thus, options should be priced at true business value.

In the whole wide world, only one corporation has never distributed any earnings to its owners except on one occasion. You would have guessed it – Berkshire Hathaway. Let’s turn to Berkshire and examine how these dividend principles apply to it. Historically, Berkshire has earned well over market rates on retained earnings, in other words, creating over a dollar of market value for each dollar retained – rarely (and I mean extremely rarely) has a corporation met this goal, not to mention that Berkshire is the only one for such a long time retain all its earnings and yet been able to do so. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.

In fact, if significant distributions were given in its early years, it would have been disastrous. Before the current mode of Berkshire Hathaway, it is operated under three entities: Berkshire Hathaway Inc, Diversified Retailing Company, and Blue Chip Stamps (all now merged). Blue Chip paid a small dividend, and the other two none. If, instead, the companies had paid out their entire earnings, it is most certain that there would be no earnings today, and perhaps running out of capital. The three companies each originally made their money from a single business: 1) Textiles at Berkshire, 2) department stores at DRC, 3) trading stamps at BCS. These cornerstone businesses then have, respectively, 1) survived but earned almost nothing, 2) shriveled in size while incurring large losses, and 3) shrunk in sales volume to about 5% its size at the time of their entry by 1984. Only by committing available funds to much better businesses were Berkshire able to overcome these origins.

The incentive-compensation system at Berkshire rewards key managers for meeting targets in their own turf. If, for example, See’s does well, that does not produce incentive compensation at the Buffalo News or vice versa. Neither does Berkshire looks at the price of Berkshire stock when they award bonus checks. It is in Berkshire that they believe good unit performance should be rewarded regardless of the overall performance of its parent – Berkshire in this case. If See’s makes $100 million in profit, See’s manager will be awarded based on the $100 million performance even if Berkshire makes a loss in that year. Similarly, average performance should earn no special rewards even if Berkshire share soar through the roof. Performance is therefore defined based on the underlying economic performance of the business – in cases where manager’s performance is due to any tailwinds not of their own making, applause should be withheld, or in other cases, if managers manage to arrest unavoidable headwinds, applause must be given.

Book Value, Intrinsic Value and Business Valuation

Let’s distinguish the difference between Book Value and Intrinsic Value. Book Value is the amount that has been pumped into a venture because whatever amount that has been invested is being recorded on the book – even if it at an overpaid price. What has been invested in a business does not guarantee what can be generated out of the business. But to make a profitable deal, what counts is what can be generated out from what has been fed into it. In this case, Intrinsic Value is the measurement of what can eventually be taken out from the business. Simply put, Book Value as a measurement or proxy for the relative attractiveness of a business or its intrinsic value is meaningless.

In reality, the value between the two is often different, sometimes vastly so. In the event than intrinsic value exceeds the book value, whoever that invested in the business got his money worth. Since intrinsic value is a calculation based on the sum of all the business cash flows during its remaining life, it pays for investors to act only on businesses which are certain to produce a steady and predictable cash flow, and at the same time, the business must not be easily vulnerable to new or current competition.

You can gain an insight into the difference between Book Value and Intrinsic Value by comparing the current earning power of an undergraduate and a blue-collar worker. The undergraduate may be earning $1000 monthly on a part-time job while the blue-collar worker is earning $2000 monthly. If the earning is treated as the Book Value, then is it a true indication of the intrinsic value of them? Obviously, the intrinsic value of the undergraduate is much higher than what his book value today suggests when he graduates.

Now, let’s do an example based on a fictitious business offer as if it is available to you as a whole. Assuming there’re two businesses making chewing gum, Wrigleys and China Gum, up for sale. Each possesses vastly different business economics and competitive advantages. Wrigleys is available at a price tag of $50 million and China Gum is available for $36 million. Each of them earns $4 million. In other words, the PE ratio is 12.5 for Wrigleys and 9 for China Gum, which will you chose? I bet most of you’d chose China Gum since it costs $14 million lesser while earning the same profit, and also, it takes a shorter time to recoup the capital invested.

Now, let’s throw in some more important information. Wrigleys’ net tangible asset is $16 million and China Gum is $36 million. This works out at a return of 25% on net tangible assets for Wrigleys and 11% for China Gum. Now, we do know a little bit more why did Wrigleys commands a premium of $34 million over its tangible assets. China Gum while making the same profit may well thus be sold for the value of its net tangible assets because the business possesses little or no economic goodwill. But then, if you pay $50 million for Wrigleys, then effectively, an investor return on the business is 8%, of which $34 million will be recorded in the balance sheet as Goodwill, and $16 million as tangible assets.

So, in this case, is it still worthwhile to buy Wrigleys over China Gum? The answer is a resounding “Yes” even if both businesses are expected to have flat unit volume as long as you anticipate a world of continuous inflation. To understand why, we must understand the workings of inflation and that it is inevitable over time.

What happens in an inflationary world? It simply means prices in the future will be higher than today for the same service or product rendered. In the long run, inflation is nothing but a certainty and it is inevitable. Imagine the impact that a doubling of price level will have on both businesses. Both would need to double their earnings to $8 million to keep themselves even with inflation. This would seem easy: just sell the same number of units at double the earlier price and assuming profit margins remain unchanged, profit must then double.

But more importantly, to bring that about, both businesses would have to double their nominal investment in net tangible assets, given that that is the kind of economic requirement that inflation usually imposes on businesses, good or bad. And all this inflation-required investments will produce no improvement in the rate of return. The reason for this investment is the survival of the business, not the prosperity of the owner.

Remember that Wrigleys had net tangible assets of $16 million. Thus, because of the inflation, they had to commit an additional $16 million to fund the capital needs. China Gum, however, had a burden over twice as large by investing an additional of $36 million in capital.

After the dust had settled, China Gum now earning $8 million annually might well be worth the value of its tangible assets, or $72 million. This means its owners would have only garnered a dollar worth of nominal value for every new dollar invested.

However, Wrigleys, also earning $8 million might well be worth $100 million (as it logically would be) on the same basis as it was originally available. So it would have gained $50 million in nominal value while its owners just put up $16 million in additional capital – over $3 of nominal value gained for every dollar invested.

Because of inflation, both businesses were forced to put up additional capital just to stay even with inflation for real profits. However, in this case, China Gum although doubling their earnings did not get any real growth in earnings because it is eaten up by inflation – they were having the same purchasing power when they earn $8 million as when they were earning $4 million. But it is different for Wrigleys, the owners got more than a dollar worth of value for each dollar invested in times of inflation. Simply, Wrigleys was beating the rate of inflation.

Any business that requires some form of tangible assets to operate (and almost all do) is hurt by inflation. Thus, businesses needing the least or little in the way of tangible assets simply are hurt the least.

The reality of this has been difficult for many people to appreciate. For years, tradition wisdom held that assets are the best protection for inflation. Thus, businesses laden with natural resources, plant and equipments, or any other tangible assets, are thought to be the best protection against inflation. But unfortunately, it doesn’t work that way. Sad to say some traditions are “long on tradition, short on wisdom.” Inflation is best protected by the earning power of the asset, not the book value. Asset-heavy businesses tend to earn low rate of return – to the point that barely provide enough capital to fund the inflationary needs of the business, with nothing left for real growth, for distribution to owners, or for acquisition of new businesses.

During the inflationary years, a disproportionate number of great businesses fortunes were built up by operations that combined intangibles or goodwill with lasting economic value with relatively small requirements for tangible assets. In such cases, earnings have spiraled upwards in nominal dollars with little in the way of additional capital, and these nominal dollars have largely been used to acquire new businesses or repurchase outstanding shares. In times of inflation, Goodwill is the gift that keeps giving.

But that statement is only valid to true economic goodwill. Spurious accounting goodwill is another matter and there’re plenty around. When a management purchases a business at a silly price, the same accounting treatment is observed. Because Goodwill cannot go anywhere else, the silliness ends up in the Goodwill account. Due to the lack of managerial discipline and business-savvy, the account was created and it is treated as an asset as if the acquisition had been a sensible one. But for any past silliness, the future pays for it. When someone try to reach for the silliness, the Goodwill just melts away and then to bring the acquisition closer to what is intrinsically worth, an impairment of Goodwill will have to be taken to make up for the past accounting shenanigans.

In taking silliness of such business deal to the forefront, imagine you are an undergraduate, would you merge your earnings, although you’re not earning a single cent today, with a plumber who earns $2000 monthly on a 50/50 basis so as to get $1000 monthly? If you merge, after you graduate, and if you command $3000 monthly, you’d then have to combine your pay with the plumber’s pay, and you’d get only $2500 because of the decision you took to merge. You think this is ridiculous, isn’t it? But that’s what has been happening in the business world where management simply is that silly – well, I can’t say they are that silly, maybe they’ve got their personal agenda to enrich themselves rather than to look after the shareholder’s value.

And the plumber said with a parting shot to the undergraduate when they merged: “Promise never to do a deal this dumb in the future.”

Investing Experience

I’m gonna to talk something which is a little detrimental to my advantage because this will increase the circle of competition in the correct method of investing. But on the whole, nature as it is, even with the facts of life staring with undisputable truth, it is hardly taken with due respect.

For the regulars on my blog, you’ll probably know that I only purchase undervalued marketable equities, regardless of the view of the general market. Most of the time, I’m swimming upstream in most of my decisions in investments. Along the swim upwards, there’re many bystanders who keep yelling “hey dude, you’re in the wrong direction.”

As at that point, if the stock price is an accurate indicator of value, I admit I’m in the wrong direction. Having said that, I realized early in my proper investing road, I’m lucky to pick up the correct concepts through the best investing teacher in history, Benjamin Graham. He said, “In the short run, stock market is a voting machine. In the long run, stock market is a weighing machine.” What is important to me is the long run, therefore, as long as I invest at a fair price – it’d be much better if undervalued – I do not care if the price I invested at would go 10%, 20% or even 30% lower than at the price I got at. I realized the stock market is like a big gambling house – although it shouldn’t be treated as one in the first place. Maybe someone should put a bouncer at the front end to screen potential gamblers from entering. But then without these gamblers, the opportunity for prices to get out of whack (in both directions) from its intrinsic value will be seriously remote. With millions of market participants, it is impossible to know what the next fool or genius will buy or sell their stocks at. Not that I don’t feel pain when I see prices going even lower than the price I considered already undervalued. I too at times rant within that I could have gotten at a better price but ultimately what counts is not tomorrow, neither does it counts a year later unless you’re only keen to show results by making the numbers. What counts will be the progress of the business at the undervalued price an investor pays for in 10 years, 20 years or even for an investor’s lifetime.

But such long-term view will seriously reduce the number of potential businesses an investor can deploy their money in. When you can find one, you should pump as much resources in that business that meets the two criteria. Furthermore, if the stock price goes down yet further, ironically, in the measurement of risk by Wall Street, risk has increased. Hello, risk has increased because stock price plunged? Volatility as a measurement of risk is total nonsense. Risk should be measured by how much you understand the business long-term competitive advantage, the price you are paying at and ultimately the present value of all future cash flows the company will produce. For me as with all true-blue intelligent investors, a yet-further depressed price only serves as an opportunity to increase your stake in a fabulous business.

Thus far, for some of the purchases I made, I feel I’m actually profiting from the eventual class of entering shareholders who took my place. For example, Stamford Land, I bought the share at 29 cents in December 2005. At that time, the price was undervalued because investors did not care about the huge gain of property gain SL will record in the subsequent fiscal year. What happened, was profit then surged by 60% if I remember correctly. SL ended at a recent high of 65 cents. At that price, people were expecting a bumper dividend but they ignored a fundamental reality that any dividend is dependent on the business cash flow capability. I sold out at a much lower price because I do not expect to catch both the bottom or should I expect to catch the top. Then finally, SL issued their 06/07 report and 3 cents dividend was given. Coupled with the high price placed on its share, investors were naturally disappointed and it went to 55 cents (although still not a terrible plunge). The lesson here is an inferior class of investors ultimately entered the business compared to the superior class of investors who bought at an undervalued price. So what really happened was the superior class profited from an inferior class of investors. The higher the price you enter in, the higher your risk. So it totally debunks the concept of volatility as a risk.

I’ll end here for now. There’ll be a part two on some other investing thoughts on the difference between book value and intrinsic value.

Misconceptions on Investing

Misconceptions come in all shapes and sizes. I swear when I ask my friend what’s the capital of Australia, many of them would reply Sydney or Melbourne. But the capital is Canberra. Similarly, in investing there are many misconstrued notions which I shall try to address here as far as I could.

Investing misconceptions are like that: The untruth is always packaged as truth even in the face of logic. I think the best way to deal with it is to continuously attack and disprove the misconceptions.

1) “Wow, that stock’s cheap at 20 cents.”

The whole concept of price per share should be done away with. The popularization of differentiating stocks into “blue-chips” and “penny stocks” are doing many ignorant investors a great disfavor. This is as if to classify stocks as in fashion into “Chanel” and “G2000.” Here the saying describes such behavior in the best light, “One who knows the price of everything but the value of nothing.”

The fact that SC Global is trading at $5.50 per share and Thai Beverage is trading at 28 cents per share does not mean that one is cheap and the other is expensive.

A share of stock can be pictured as a piece of the cake. The fact that I’ve five cherries on my slice and you have two doesn’t mean my slice is superior to yours. What is important is how big the cake is, and what ratio or percentage your slice comprises in relation to the cake.

What should investors then focus on? A company’s market capitalization is the price per share multiplied by the number of shares outstanding. The enterprise value is the market cap plus net debt. Investing in marketable securities must be treated as if one is examining to buy a private business as a whole. If you were to buy SC Global, despite its “sky-high” per share price, you’d only pay $870 million (the market cap) for the whole business. Compared to Thai Beverage, which is nearly 8 times as costly at $7 billion market cap.

The gist in how to think about prices in investing is to think price in terms of value that you’ll eventually get out of it.

2) “I want to buy at the bottom and sell out at the top.”

I’m at times as guilty as anybody of trying to time the bottom as well as the top. I get upset when a stock drops immediately after I buy and goes up immediately after I sell. One can go on a tantrum and complain loudly about how this always happens.

The truth is it’s very foolish to think one can catch the bottom or top on a regular basis. The stock market is a gigantic auction where millions of people participate in, buying or selling every day. When I buy or sell a stock, I’m selling or buying to or from one of those millions. It’d be impossible to predict what those millions of other people are going to do the second after I execute my trade.

Then what should investors focus on? I believe that investor’s performance can be enhanced immensely once they realize the futility of trying to time a top or a bottom. It’ll stop foolish thinking, and promotes thinking such as “What is the best estimate for the intrinsic value of the stock?”

It is important to recognize two super-contagious emotions which will affect an individual investing record if they are not kept in check: Fear and Greed. These two emotions will remain forever in the investing community and will swing from one end to the other at different time in point. The timing of these emotions will be equally unpredictable, both as to the duration as well as the degree. Therefore, one should never try to anticipate the arrival or departure of either emotion. The goal of an investor should simply attempt to be modest when looking at how to profit from the folly of the others: “To be fearful when others are greedy and to be greedy when others are fearful.”

As this is written, little fear is visible in a few quarters in the stock market – the high valuation awarded to China stocks, Singapore property sectors, and to a certain extent, the risk undertaken by loaners to borrowers to finance property. We have seen in the past how foolish lenders can be in extending loans to borrowers without proper risk/reward probability taken into consideration.

There’s nothing more exhilarating than to participate in a bull market in which the rewards to the investors are effortless. Unfortunately, if the stock performance becomes uncoupled with the business underlying economics, the rewards simply melts away when it is reached for. Simply, stocks can’t outperform the businesses indefinitely. When called upon, the stock performance will either enhance or contract closer to the underlying business value, based on the past valuation by the market.

Moreover, because of transaction cost, which can be hefty for those with “professional” helpers, stockholders as a whole and over the long term must inevitably underperform the company they own. If STI businesses as a whole earn 12% on equity annually, investors as a whole must end up earning significantly less. Bull market can obscure mathematical laws, but they cannot repeal them.

3) “Great company, great investment.”

When it comes to investment, two things counts, the length of time you hold it and the price you pay. An investment in a great business by paying a dear price is no great investment. By paying a dear price, one is actually paying for business earnings of well-many years down the road. Eventually, a business will need a period of time to play catch-up for a high-price-paid-today stock.

4) “Falling in love for a hot stock.”

It is hard to resist a sexy lady’s advances for a date at any time. The problem is the trouble always begins much later when the things that really counts begin take its shape. After all, who could resist a temptation when it promises one all the goodies? Except that the goodies last for a short period. Similarly in stocks, investors get suck into a full-blown romance and fall in love with a stock’s story. Emotion will cloud their judgment when it comes to assessing valuations, and its growth and economical prospects.

Enron is a classic example. A company operated by con artists at the very top who are disguised as angels in selling the company to investors. Investors are being pursued by Enron, just very much like a guy who does nothing but get ask for a hot date with a hot chick. The problem is everything beneath the beautiful surface is nothing but a can of worms.

Solving the man with a hammer syndrome

Charlie Munger always quoted the following symptom of human: “To a man with a hammer, everything seems like a nail.”

For most CFO or CEO of any operating business, they would more often than not come across a situation where they have to make a decision either to deploy capital in some newly available machinery or process in the market.

Imagine you are the CFO of a textile company which makes commodity yarn. The industry in which you operate is extremely competitive beset with excess capacity.

A leading textile machinery manufacturer’s marketing agent approaches you with a proposal to sell you a new loom which is more efficient than any other loom available in the market. He informs you that the new invention is far more efficient and that it’ll save your company a substantial sum of money every year, so that it will pay for itself in a very short span of time. To justify his claims, he presents you with the following figures: 1) The cost of the machine at $100 million, 2) expectancy lifespan of 10 years, 3) savings in operating costs for the next 10 years at $25 million annually, and 4) expected residual value of the machine at $10 million.

The CFO then verified the numbers presented to him and find them to be accurate. His company’s pre-tax hurdle rate (cost of capital) is 15% p.a.

Should the CFO’s company then place orders to buy these looms?

Using the skills in the Discounted Cash Flow model, the CFO quickly determine the Net Present Value, which is large and positive, and conclude that the loom should be purchased and installed as soon as possible.

The main problem with this approach is that it often leads to the wrong conclusions because of the over-use of the DCF model in finance and ignorance of appropriate models from other disciplines such as microeconomics, game theory and psychology.

Charlie Munger call this “the man with a hammer” syndrome. If all a man has is a hammer, he’s going to end up using it for all situations.

How can one then deal with this syndrome? Well, the best way, according to Mr. Munger, is to train oneself to “jump jurisdictional boundaries” and grab the most appropriate models from multiple disciplines that best solve the problem at hand. In his words, one must have a “latticework of models.”

The present problem needs a two-step analysis drawing on models from multiple disciplines before coming to a conclusion.

The first step involves using the DCF analysis, which the CFO has no problem at all. That part of the analysis has been done and shown in the table above.

It’s the second part which the CFO misses. He misses it because he isn’t trained to think in a multi-disciplinary manner.

That second part of the analysis requires him to answer the following question: How much of the cost savings that the new loom will deliver be kept by the business and how much of it will flow to the company’s customers?

Now that gets a bit tricky, isn’t it? It gets tricky because to answer that question one has to grab models from microeconomics – such as the model of competition. And, surely, when you look at it from that angle, it’s obvious, that given the nature of the textile industry’s competitive nature, arising out of surplus capacity and commodity attributes of the products, most of the cost savings from the new loom will flow to the customers, not the owners. In other words, whatever additional capital the business spent, the business will gain not much of the anticipated savings that was presented by the marketing agent of the new loom.

This will happen because once a textile company acquires the new loom and achieves the promised cost savings, it’ll tend to either lower its prices to gain market share, or keep prices unchanged to earn higher margins. Sooner rather than later, these two actions would get noticed by the company’s competitors and they would naturally rush to make the same investment in the new looms, in order to regain market share or to earn higher margins. Ironically, the very salesman who sold the loom to the original textile company will rush to sell it to its competitors and cite the original textile company cost-saving achievement as a reason for your competitors to buy his company’s new invention. After all, he is not in the business to make your production process more efficient. He is in the business of making money for his company. And Charlie would say: “Whose bread I eat, his song I sing.”

In this problem, competition i.e. the absence of a cartel will ensure that almost all of the efficiency gains end up in the pockets of the buyers of textiles, and not in the pockets of the owners of the textile companies.

Another irony arises out of the fact that this tragic outcome would occur even though all of the promised efficiency gains materialized. It’s not that the new looms aren’t any good. In fact they are so good that any advantage for the early buyers will prove to be temporary illusion because sooner or later everyone has to have one or they risk being perished.

Such is the nature of certain businesses where you have to keep on putting more and more money in just to stay where you are. (It’s like attending a concert and you find those in front of you taller and you tip your toes to get a better view. But sooner the ones in front too face the same problem and they tip their toes too.) And you can keep on investing money in projects which are calculated to have positive NPVs and high internal rate of returns and you can still end up earning substandard returns on capital that destroy shareholder’s value if the CFO does not recognize the danger of the “man of a hammer” syndrome.

On the other hand, if we were dealing with the world’s largest beverage company like The Coca Cola Co., an almost monopoly where the buyers of its drinks are price-insensitive addicts. In addition, such business has what Warren Buffett terms as having a certain untapped price advantage. If someone sold a more efficient machine to make Coke, then the cost savings from this new wonderful invention will not be passed on to the customers and instead be retained by the business. Rather, much of the post-tax cost savings would accrue to the benefit of Coca Cola’s shareholders.

Without jumping over the jurisdictional boundary of finance where DCF resides, into the jurisdictional boundary of microeconomics where the model of competition resides, the CFO cannot solve the problem at hand in a satisfactory manner and may make an unwise decision when it comes to the deployment of capital. CFO must not only be good at numbers, they must in fact to good at thinking in a broad spectrum in order to make a logical capital deployment decision.

In early 1980s, Mr. Warren Buffett faced a similar dilemma in the management of the unprofitable textile business of Berkshire Hathaway. He knew that the U.S. textile industry was going to become increasingly uncompetitive, primarily due to its high, and impossible to reduce, labor costs. He also knew that he had other opportunities in which he could invest capital where the prospects of earning superior returns were excellent, given the fundamental economics of those businesses then available.

Long before most capitalists would even consider the possibility, in 1985, Mr. Buffett decided to shut down the textile operations of Berkshire and redeploy the capital in better businesses. It proved to be one of the best business decisions he ever made although it is one of his worst decision ever made when he initially bought Berkshire. In a letter written to the shareholder’s of Berkshire in 1985, he reasoned:

“The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry wide. Viewed individually, each company’s capital investment decision appeared cost effective and rational; viewed collectively; the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”

Mr. Buffett utilized the metaphor of a parade to illustract a well-known problem in game theory called “Prisoner’s Dilemma.”

Prisoner’s dilemma involves two suspects, A and B, who have been arrested by the police. The police have insufficient evidence for a conviction, and, after separated both prisoners, offer each the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both stay silent, the police can sentence both to only six months in jail for a minor charge. If each betrays the other, each will receive a two-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So the question this dilemma poses is: What will happen? How will the prisoners act? The dilemma is summarized in the following table.

The dilemma came about when one assumes that both prisoners only care about minimizing their own jail terms. Each prisoner has two options: to get a light sentence by cooperating with the police by betraying his accomplice, or to stay to the pact and keep quiet. The outcome of each choice depends on the choice of the accomplice, but the player must choose without knowing what their accomplice has chosen to do.

Let’s assume prisoner A is working out his best move. If his partner stays quiet, his best move is to betray as he then walks free instead of receiving the minor sentence. If his partner betrays, his best move is to betray, as by doing it he receives a relatively lesser sentence than staying silent. At the same time, the other prisoner’s thinking would also have arrived at the same conclusion and would therefore also betray.

If reasoned from the perspective of the optimal outcome for the group (of the two prisoners), the correct choice would be for both prisoners to cooperate with each other, as this would reduce the total jail term served by the group to one year total. Any other decision would be worse for the two prisoners considered together. When the prisoners both betray each other, each prisoner achieves a worst outcome than if they had cooperated.

In other words, actions that appear to be rational from an individual’s perspective sometimes become foolish, when viewed from a group’s perspective. The functional equivalent of the prisoner’s dilemma in our problem at hand creates miserable choices but would we have discovered that unless we had jumped over into the jurisdictional boundary of game theory? I think not.

So, we grabbed DCF from finance, and then jumped over its jurisdictional boundary into the territory called microeconomics, where we grabbed competition. Then again we jumped over the fence into the boundary of game theory where we grabbed prisoner’s dilemma.

Now we are one jump away from, last but not least, jurisdiction of psychology. And then we can stop hopping about and solve the problem.

One model we will grab from psychology is what Mr. Munger calls “bias from commitment and consistency.” When you have already made prior commitments to pet projects, you may find it hard, even impossible, to reverse your position and change course. If old reasons are no longer valid to support original decision, new ones shall be invented. Man, after all, is not a rational creature, but a rationalizing one.

Yet another model to be grabbed from psychology is called the “contrast effect.” One version of the contrast effect makes small, incremental escalations in commitments go unnoticed, particularly when these escalations are carried out over a long period of time.

It works in brainwashing techniques. And it also contributes to foolish business decisions.

If you’ve already sunk in $100 million in a bad capital investment project, an additional investment of $100 million will look very small in contrast to the much bigger total commitment already made and will therefore tend to go unnoticed.

This version of contrast effect is also known as the “boiling frog syndrome:” If you put a frog in boiling hot water, it will jump out instantly, but if you put a frog in room-temperature watch and then slowly heat it, it will boil and die.

Of course, the story of the boiling frog isn’t true. That metaphor, however, is highly appropriate because the human equivalent of the boiling frog is there in all of us.

Mr. Buffett and Mr. Munger could see that bias from commitment and consistency and the boiling frog syndrome from psychology often combine with the prisoners’ dilemma model from the game theory, making many businessmen take unwise decisions by continuing to sink more and more money in a lousy business instead of taking money out and redeploying it more productively elsewhere. He realized that in some industries the chief problem is that if you continue to remain in the game, then “you can’t be a lot smarter than your dumbest competitor.”

Thus, they wisely refused to play this game and withdrew his capital from the textile business and reinvested in businesses with much better fundamental economics like Coke, Gillette, Capital Cities, and Nebraska Furniture Mart. Over time, his decisions to shut down the textile operations of Berkshire and to reallocate the released capital elsewhere have made its stakeholders richer by tens of billions of dollars.

Mr. Buffett’s and Mr. Munger’s multidisciplinary mind helped them solve a complex business problem. If CFO could learn to apply such thinking style instead of just relying on a single model, there would be a lot more happy stakeholders around.

Otherwise, most CFO are destined to remain as the “man with the hammer.”

Buffett on risk and diversification

Excerpt from Berkshire Hathaway’s 1993 Letter to Shareholders.

The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well DECREASE risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks – that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the “beta” of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

For owners of a business – and that’s the way we think of shareholders – the academics’ definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market – as had Washington Post when we bought it in 1973 – becomes “riskier” at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?

In fact, the true value investor WELCOMES volatility. Ben Graham explained why in Chapter 8 of THE INTELLIGENT INVESTOR. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrational low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be though of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company’s name. What he treasures is the price history of its stock. In contrast, we’ll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company’s business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s or H.H. Brown to validate our well-being. Why, then, should we need a quote on our 7% (8.5% at end 2006, the amazing thing is BH did not even need to buy a single share since 1988 to increase their interest to 8.5%, and it’ll be interesting for you to think why it is so) interest in Coke?

In our opinion, the real risk an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;
2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
3) The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to himself;
4) The purchase price of the business;
5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

These factors will probably strike many analysts as unbearably fuzzy since they cannot be extracted from a data base of any kind. But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable. Just as Justice Steward found it impossible to formulate a test for obscenity but nevertheless asserted, “I know it when I see it,” so also can investors – in an inexact but useful way – “see” the risks inherent in certain investments without reference to complex equations or price histories.

Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than, say, any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than 60% share (in value) of the blade market. Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power.

Moreover, both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle without any such means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: “Competition may prove hazardous to human wealth.”

The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage. Should we conclude from this similarity that the competitive strength of Coke and Gillette gains them nothing when business risk is being measured? Or should we conclude that the risk in owning a piece of a company – its stock – is somehow divorced from the long-term risk inherent in its business operations? We believe neither conclusion makes sense and that equating beta with investment risk makes no sense.

The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it’s quite possible for ordinary investors to make such distinctions if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness. Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.

In many industries, of course, Charlie and I can’t determine whether we are dealing with a “pet rock” or a “Barbie.” We couldn’t solve this problem, moreover, even if we were to spend years intensely studying those industries. Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly-evolving businesses? We’ll stick instead with easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?

Of course, some investment strategies – for instance, our efforts in arbitrage over the years – require wide diversification. If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for possibilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of a casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term investor of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitation, it ceases to be “dumb.”

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In other words of the prophet Mae West: “Too much of a good thing can be wonderful.”

Warren Buffett's quotes on risk

“Wide diversification is only required when investors do not understand what they’re doing. If you have a harem of 40 women, you never get to know any of them very well.”

“Risk can be greatly reduced by concentrating on only a few holdings.”

“Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.”

How to handle risk you totally have no understanding in? “There’re all kinds of businesses that Charlie and I don’t understand, but that doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the individual investor should do.”

“The strategy (of portfolio concentration) we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it rises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”

“In stating this opinion, we define risk, using dictionary terms, as the possibility of loss or injury.”

“We think diversification, as practiced generally, makes very little sense for anyone who knows what they’re doing. Diversification serves as a protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There’s nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyze business.”

“But if you know how to value business, it’s crazy to own 50 stocks or 40 stocks or 30 stocks, probably because there aren’t that many wonderful businesses understandable to a single human being in all likelihood. To forego buying more of some super-wonderful business and instead put your money into #30 or #35 on your list of attractiveness just strikes Charlie and me as madness.”

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you’ll find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

“John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thoughts, wrote a letter to a business associate, F.C. Scott, on August 15, 1934 that says it all: ‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence….One’s knowledge and experience are definitely limited and there’re seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.”

“I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.”

“In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.”

Munger notes from Wesco Financial 2007 meeting

Charlie Munger presided over the annual meeting of Wesco Financial (AMEX:WSC), 80% owned by Berkshire Hathaway (NYSE:BRK-A). Wesco has a property and casualty business, reinsures banks, has a furniture rental business and a steel business. In addition, it has an investment portfolio that includes Procter & Gamble, Coca Cola, American Express, fixed-income, and cash.

Charlie began the meeting by saying that he didn’t set out in life to become the assistant leader of a cult.

The body of Charlie’s talk this year focused on the reasons why Buffett and Berkshire Hathaway become such a “lollapalooza” success. He gave several reasons that, working in concert, led to one of the most spectacular investment and business records in the history of capitalism.

Those factors are:

1) Mental Aptitude: Warren Buffett is obviously a very smart man, but Charlie stated he probably overachieved because of his innate mental ability. For example, Buffett could not “beat all corners playing chess blindfolded” like U.S. chess champion Patrick Wolff. (Wolff beats multiple opponents simultaneously while blindfolded at Berkshire Hathaway annual meetings.) Using the dry humor of a ridiculous understatement, Charlie called Wolff’s skill “interesting.”

2) Intense Interest: Charlie noted that Buffett was intensely interested in business and investing from a very young age. “There’s no substitute for a very intense interest.”

3) Early Start: Another factor in the success of Berkshire Hathaway was that Warren got an early start and was able to use his skills to compound capital over many decades.

4) Constant Learning: Charlie stated that Warren is one of the best “learning machines.” The key to success is to continue learning throughout your life with a voracious appetite. Charlie later circled back to this topic when he said the best way to gain wisdom was by “sitting on your (behind) and reading all day.”

5) Concentration: Another factor in Berkshire’s success was that the work was heavily concentrated in Warren’s mind. “It’s hard to think of committees that have been successful.” He suggested that investment committees usually do not come up with great ideas because there’re too many people involved. Charlie used the analogy of John Wooden’s player rotation strategy. The great UCLA basketball coach would only play seven of his 12 players, so as to concentrate the experience of his seven best players. Similarly, most of Berkshire’s work was concentrated in its best mind, Warren Buffett’s.

Then he mentioned the following notes with humor and clarity. Charlie dispenses advice for living a well-balanced life. Here are some nuggets of wisdom.

1) Charlie stated that many smart people handicapped themselves with “nuttiness.” One example is being an “extreme ideologue,” which is the equivalent of “having taken your brain and started pounding it with a hammer.” He then gave Mozart as an example. Mozart was a brilliant composer but did nutty things like spend all of his money. He said it is fun to be rational and fun to be rightfully trusted by others. Berkshire Hathaway was run with trust. They did not need layers of bureaucracy and oversight.

2) Your life must focus on the “maximization of objectivity.”

3) “You must learn the method of learning.”

4) “It’s totally unproductive to think the world has been unfair to you. Every tough stretch is an opportunity.”

5) “You can get away with more than you deserve in life by being slightly more rational.”

6) “I’m not going to complain about my age because without it, I’d be dead.”

One questioner asked about a closed held belief that Charlie had recently overturned. After some thinking, Charlie responded that Berkshire’s recent purchase of railroad stocks marked a 180 degree change in thinking about the industry. According to Charlie, he did not like them because railroads needed large amounts of capital, had tough unions, and stiff competition from the trucking business. He said that their paradigm had shifted and that they were two years too late in making his investment. He used an old quote and said that man is too old too soon and too smart too late. Now the railroad industry has a competitive advantage over trucking because of innovations such as double-stacked cars and computer modeling of routes. With the imports from China, the U.S. has a huge amount of freight being sent across the country. Charlie said that Bill Gates made an investment in a Canadian rail company and made “multiples of his money.” He quipped that maybe Gates should be managing Berkshire.

Then he touched on the hot topic of global warming which was raised. Charlie thinks it’s not as big a deal as everyone says it is. He says that it is very difficult to change the path that we are on and we have no influence over emerging countries. He went on to say that global warming changes take place over a very long period of time and used as an example one hundred years. He said we can adjust over long periods of time. If Florida is flooded because it is a low elevation, people will have time to move.

Charlie gave two book recommendations. The Martian of Science: Five Physicians Who Changed the Twentieth Century by Istvan Hargittai and Einstein; His Life and Universe by Walter Isaacson. Charlie said he had read every Einstein biography, and this new one by Isaacson is the best.

He said there are two kinds of inefficient markets: one that are small and neglected and one where people do crazy things. The latter happens from time to time.

More from Berkshire 2007 annual meeting

DERIVATIVES
Buffett said there’ll be something similar to the collapse of Long Term Capital Management in 1998. They don’t know when or what it will look like, but it could be bigger than before. He says derivatives make margin regulation a joke and will bring chaos.

According to Charlie Munger, most of the accounting profession doesn’t know how stupidly it is behaving, especially accounting for derivatives. By marking to market derivative positions, traders are being paid for profits that may or may not materialize, and increasing risk in the financial system as returns relative to risk are lop-sided for the trader. The aggregate balance sheet for all derivatives almost certainly doesn’t balance. In some cases, profits on different sides of the same trade are being accounted for differently, creating the illusion that profits are higher than they actually are. Traders will game the system to make its trade benefit itself as opposed to presenting an accurate reflection of profitability.

Charlie also noted the number of people who are seeing record profits thanks in part to derivatives. As we know, with record profits come record executive bonuses – and just as the monkey will do whatever it takes to get the banana, Charlie said those executives will also continue to do exactly what they’re doing to get their bonuses, tenable or not.

CORPORATE PROFITS
Buffett said corporate profits are today extraordinary and not sustainable. Over time, corporate profits have averaged 4% to 6% of GDP. Today it is 8%, and that will come down. Much of today’s profits are being derived from the financial sector.

HUMAN FALLIBILITY
People have a hard time thinking about what hasn’t happened in the past, Buffett said. Thus, they tend to incorrectly discount events in the future. On desired hurdle rates, it is amazing how gullible big investors, such as institutions, are. They’re willing to believe and invest with people who will tell them what they want to hear, even if those people cannot deliver the stated hurdle rate.

ASSET ALLOCATION
Someone asked if Buffett is the head of a $10 billion endowment, would his choice be stocks, bonds, cash, or a mixed, he said it would be 100% in stocks if his time frame is 20 years. However, he believes future returns will be moderate. They do not have high expectations for equities over the next 20 years but, equities will earn more than the 4.75% you will receive from bonds. There’ll be a severe dislocation at some time. He doesn’t believe in traditional asset allocation – 60% in equities, 30% in bonds and 10% in cash. You should invest entirely in stocks, bonds or cash. According to Charlie, opportunity cost is what you want to base your investing decisions on.

THEIR SILVER TRADE
“I bought it too early, [and] I sold it too early,” Buffett quipped. “Other than that, it was a perfect trade. That shows you how much we know about silver. I’m flattered you asked because no one asks us our opinion on silver anymore. Commodity prices are determined by supply and demand, not conspiracy theories.”

ASSET SIZE IN RELATION TO INVESTMENT STRATEGY
If Buffett were working with a small fund, he would be investing totally differently. According to Charlie, the area where you should look for investment ideas when you are young is in inefficient markets.

VOLATILITY AS A MEASURE OF RISK
Buffett said volatility is not a measure of risk. The people who teach risk in universities do not understand risk. Beta does not measure risk. Warren gave the example of a Nebraska farmland which he purchased in the early 1980s, for $600 an acre. Two years earlier, it was selling for $2000 an acre. However, when farmland was selling at $2000 an acre, its beta (risk) was lower. Thus, according to financial theory, farmland was less risky at $2000 an acre than it was $600 an acre. He went as far as to suggest “volatility as a measure of risk is nonsense.”

He believed volatility arises from not knowing what you are doing. Using volatility as a measure of risk is useful for people who wanted a career in teaching. According to Charlie, 50% of financial theory as taught in universities is “twaddle (nonsense).” Charlie went on to quip, “Very smart people do very dumb things,” and it is important to “know who those people are and avoid them.” People who talk about volatility being an accurate reflection of risk are crazy. You would have to believe in the tooth fairy to believe that Gaussian equations are a measure of risk in capital markets.

MEETING THE MANAGEMENT
Buffett does not believe in meeting the management when buying marketable securities. They will instead read a lot, particularly annual reports. When they receive dishonest messages in the corporate literature, they avoid those companies. If consultants or the business write the message “why invest with someone who is responsible with your capital but won’t talk to you once a year,” then you should meet with the management before investing.

PICKING YOUR HEROES
According to Charlie, “you’re not restricted to picking living people as your heroes. Some of the best people are dead.”

2007 Woodstock for capitalism

May 5, 2007, a crowd of 28,000 packed the Qwest Center, of which roughly 24,000 were repeated audience from last May. All were there on that Saturday morning, as early as 6am, waiting for the long-awaited annual festivity and meeting of Berkshire Hathaway, chaired by Warren E. Buffett and Charle T. Munger. For serious investors who flocked to Omaha, this is the Woodstock for capitalism – an opportunity to pick up a few invaluable investment and life lessons.

Buffett on young investors
Given the number of youthful shareholders running around the exhibit hall, Matt Koppenheffer, a writer from Motley Fool, asked Buffett for his thoughts on what young investors should do with their money. Warren started by cautioning that even though youngsters need to learn good financial habits early on, not all of them should be getting involved in investing, even if they do have a keen interest in stocks – just as he did at an early age. He suggested it’s just as important that young people understand, for example, that “credit cards can cost you a lot of money,” and he said he’s currently working on a cartoon series with DiC Entertainment Chief Executive Andy Heyward that will be aimed at educating the young on good financial habits.

On private equity
An audience, noting that private-equity managers are chasing all kinds of deals – some of questionable quality – and using a lot of leverage, asked Buffett what he thought could burst this bubble and what will happen when it does pop.

Buffett quipped that the scenario presented in the question nearly brought him to tears and pointed out that Berkshire has to compete with many of these firms to secure the large acquisitions that it wants to get done, making it harder to close large purchases that can move the company’s needle. But he added that the private-equity phenomenon really doesn’t lend itself to the bubble-bursting analogy. Because the money is tied up for long periods of time and there’s no easy scorecard with which to check in on the value of the acquisitions, he said, it could take quite a while before investors become disillusioned with the private-equity industry.

Buffett, though, does seem to think that disillusionment will eventually come and that the money spigot will get twisted at least a couple of turns downward. He also pointed out that spreads on junk bonds versus high-grade bonds are very low (low junk-bond yield), and if that spread widens, it will likely slow down the rate of private-equity activity we see now.

Although private-equity increases the competition for marketable securities, Berkshire doesn’t participate in auctions of businesses, thus, it is able to avoid some of the competition from private-equity firms. To Berkshire, he added, this is consistent with Berkshire’s stated efforts to find long-term business partners, which is in stark contrast to the current “flipping” of businesses by some private-equity funds these days.

On investing overseas
Another shareholder wanted to address Berkshire’s overseas investing record. This speaker argued there are plenty of great stocks and businesses outside the U.S. and that they can be had for a discount versus what a similar business would cost here.

To illustrate that he doesn’t have anything against investing internationally, Buffett began his reply by saying he bought his first overseas stock 50 years ago. He then said that while the company hasn’t marketed itself as an acquirer in other nations as much as it has here in the U.S., that approach is evolving.

Berkshire, of course, recently acquitted Israel’s Iscar. And in terms of publicly-traded stocks, Buffett pointed out that his company does own shares of overseas companies. He specifically pointed out POSCO (NYSE:PKX), a South Korean steelmaker, though PetroChina (NYSE:PTR), the stock that’s has been causing Berkshire some concent in regard to the Sudan situation lately, is another example. Buffett also added Berkshire owns a good deal of overseas stocks that it isn’t required to disclose. As always with his holdings, Buffett prefers not to show his cards unless required to do so.

On manager’s compensation
Private equity is one of the key hot-button issues relating to the market lately, and CEO pay is certainly another. Not too long ago, there was a furor surrounding how much compensation was being given to the now-departed chief executive of Home Depot (NYSE:HD) – interestingly enough, a Berkshire holding.

It’s easy enough to guess that Buffett, who pays himself all of $100,000 per year – with no stock options to boost that figure – is opposed to the egregious packages that many CEOs take home. He began his answer, though, by saying that whether you’re talking about Procter & Gamble (NYSE:PG), Coca Cola (NYSE:KO), or American Express (NYSE:AXP) – again, all Berkshire holdings – the most important thing is making sure you have the right person running the business.

Of all the boards Buffett sits on, he was elected to the compensation committee of just one, and he says that company subsequently regretted its decision, Regarding how companies pick their compensation committees, he quipped, “they’re looking for Cocker Spaniels with their tails wagging, not Dobermans. I try to pretend that I’m a Cocker Spaniel just to get on the board,” but they uncovered him.

Riffing further on executive compensation and benefits, Buffett reiterated Berkshire’s policy of compensating people based on what they actually do and what they have control over. Here he specifically cited oil companies and the rising price of their products. Although a high oil price may give a profit boost to the likes of Exxon Mobil (NYSE:XOM) or BP, Buffett contends that shouldn’t necessarily translate into a bigger bonus for the executives at those companies, since it was not their actions that led to the higher oil price.

On corporate jets
One shareholder cited a study that said that companies with corporate jets under-perform by 4%. Munger, in his usual wit, replied: “I want to report that we are solidly in favor of private jets.” Berkshire owns NetJets, a company that allows customers to own time-share lots in private jets. Buffett, joking that Munger used to take the bus to travel, and then only when there was a senior-citizen discount available, said he has since persuaded Munger to buy a NetJets share.

On the credit markets
A question came up over how well Berkshire would deal with a serious tightening of credit – a timely topic, given how loose credit has been in recent years. Buffett pointed out that the Federal Reserve itself was created as a result of huge credit contractions and is designed to control major swings in the credit market. He seems to believe that the only way a major credit tightening would happen is if it were by design – and most authorities, he said, are not too keen to step on the brakes. Munger added that if a huge adverse credit event unfolded, there would probably be legislation introduced to mitigate the effects.

In terms of Berkshire, both Buffett and Munger pointed out that they have been able to make serious money when the credit markets have gone bonkers. Buffett went as far as to say that “we benefit when others suffer to some extent.”

Buffett also brought up the example of Long-Term Capital Management, the hedge fund that lost billions in 1998. He said there were lots of people with seriously high IQs on Wall Street who were doing some very silly things that helped that situation unfold. He then cited the famous Mark Twain quote that “history doesn’t repeat itself, but it does rhyme” and said he believes we’ll eventually encounter another situation that “rhymes” with 1998.

On shorting
Working through a question regarding issues with Wall Street firms and stock deliveries, Buffett strongly emphasized that he has nothing against shorting stocks. He said he’d be happy if someone shorted Berkshire’s stock, since, as he put it, the one sure buyer of a stock is a guy who shorted it. He added that he’d also be fine if someone decided to naked short Berkshire stock.

Continuing, Buffett specifically called out the example of Wallboard manufacturer, USG (NYSE:USG). When the company hit really hard times, a major Wall Street firm came to Berkshire and asked to borrow millions of shares. Berkshire was paid interest while the shares were borrowed. “I wish they had borrowed more,” Warren quipped and added, “Those guys didn’t do too well shorting USG at $4, either.”

On gambling
Gambling stocks have seen some nice returns over the past year, whether you’re talking about MGM (NYSE:MGM), Wynn (Nasdaq:WYNN), or Las Vegas Sands (NYSE:LVS). One shareholder asked if the dynamic duo whether gambling would continue to be a good business.

Buffett figured the industry will have a great future as long as gambling continues to be legal. He said the human desire to gamble is huge and cited how much more exciting a football game, even a boring one, can become just by betting a few dollars on it. Therefore, he believes, the easier it is for people to gamble, the better the gambling industry will do.

As for his personal feelings on the industry, Buffett calls gambling a “tax of ignorance,” with the “ignorant” defined as people who continue to put their money on the line when the odds are against them.

Munger followed up: “It’s a dirty business, and you won’t soon find a casino in Berkshire Hathaway.”

On being a better investor
A 17-year-old shareholder who has been to 10 straight Berkshire annual meetings asked what he should do to become a better investor.

Not surprisingly, Buffett went straight to the books. That is, he told the teen to read everything related to investing that he could get his hands on. Buffett said he was still young when he had already read every book – some of them multiple times – in the Nebraska public library having to do with investing. He didn’t quote names, but it’s hard to go wrong with classics such as “The Intelligent Investor”, Peter Lynch’s “One Up on Wall Street”, or John Bogle’s “Common Sense on Mutual Funds.” This will help fill your mind with competing ideas and viewpoints. He went on to say to “think about what makes sense over time.”

Buffett cautioned, though, that the difference between investing on paper and investing with real money is like the difference between reading a romance novel and, as he put it delicately, “doing something else.” “There’s nothing like having a little experience in investing,” he said. Once you’ve done that, you can decide whether, Buffett said, “it turns you on.”

He gave a not-so-surprising suggestion to always look a stock in terms of the whole company. So for example, if you’re thinking about buying General Motors (NYSE:GM) at $30 per share, he said, you should consider whether you think the entire company is really worth $18 billion. To paint a clearer picture, GM is valued at $18 billion for the whole business and it lost $2 billion in 2006 and make only $62 in 1Q07. Johnson & Johnson (NYSE:JNJ) is valued at $187 billion and earned $11 billion in 2006. Thinking in this way will give a better understanding of the opportunities and the risk of a particular investment.

There was an unspoken lesson in this answer. Like the famous Michael Jordan “Be like Mike” advertisement campaign, though Buffett wouldn’t say it himself, but the advice the Oracle gave the teen Berkshire investor could easily be summed up in three words: “Be like Warren.”

Current investment advice
Munger said: “It’s not a time to swing for the fences.”

In a brief interview earlier with CNN, Buffett remained bullish about the stock market, even amid DOW 13,000 and its best win streak in 80 years.

“To get 5.4% of gains per year, the Dow will have to end this century at 2 million. So you better get used to announcing the little milestones,” he said.

He was also upbeat about the resilience of consumer spending despite gas prices that are approaching record highs. “Gasoline, here, of course is still very cheap compared to costs around the world,” he noted. “We can overcome an awful lot of things that seem like temporary problems in this country.”

But Buffett had a decidedly different view about the housing market. He said too many homes were bought by people carrying mortgages with little or no money down who then hoped to flip them quickly for a profit. “The housing market is sick and it’s going to stay sick for a couple of years” he opined.

Avoid the big mistakes
A shareholder asked about some of the keys to his success. Buffett said that part of his success was due to avoiding some of the big mistakes. This is consistent with the margin of safety concept developed by Ben Graham. He said the principles he learned from Ben early in his life were vital, as he has been constantly applying them over the last 50 years.

How to understand risk
Another shareholder asked about how to measure the risk of an investment. Buffett said that risk is best mitigated by understanding the economics of the business you are considering investing in, as this helps an investor avoid a permanent loss of capital. He added that using volatility through a calculation of beta has been accepted by many investors because it’s a somewhat simple mathematical formula, but in his view, it’s an incorrect way to measure the risk of a potential investment.

How to handle inflation
A shareholder asked how to protect oneself and Berkshire against the risks of inflation. Buffett said: “The best protection against inflation is your own earning power.” This means that if you are in a profession that is in demand with decent pricing power, you’ll be better able to weather the risks of inflation than some of your counterparts in lower-earning professions. As for Berkshire, he said, “the second best way is owning a wonderful business.” He went on to say that by “a wonderful business,” he means one with low capital requirements and flexible pricing, as this would allow the business to raise prices in an inflationary environment.

Munger’s advice
On life advice, he said, “it would be very hard for you to fail if you stay faithful to what you set out to do.”

On opportunity cost, he quipped, “in the real world, your opportunity costs are what you want to make your decisions on.”

On margin of safety, he said, “margin of safety is getting more in value that you are paying.”

Views on the Dollar
A shareholder asked Buffett about his views on the potential for further weakening of the U.S. dollar. Buffett said that given the current economic course of the country, he still thinks the dollar could weaken further. He also added that he prefers to take positions in companies with foreign earnings rather than taking direct currency positions against the dollar. That said, he also noted that his view on the dollar is not the driving factor behind his investment decisions, but rather one of many.

Buffett on railroads
“What was a terrible business 30 years ago is a better business now,” Buffett said. But “it will never be a sensational business.”

He called railroads a “very capital-intensive” business, but said there “isn’t a whole lot of new capacity” and “it could be a lot better business than in the past.”

Buffett on sub-prime mortgage
Buffett told shareholders that he thinks the sub-prime mortgage meltdown is a problem for the companies involved, but it is unlikely to spill into the overall economy.

He quipped, “I think that’s dumb lending and it’s dumb borrowing.”

But he said as long as unemployment and interest rates don’t rise considerably, it should not cause widespread problems.

He noted securitization of the loans has made the problem worst. Sub-prime loans are often packaged up and sold on again to investors as mortgage-backed securities. He said, “Once you package those things and sell them through major investment banks, discipline leaves the system.” Sub-prime borrowers have been missing their first and second monthly payments recently and he said, “that shouldn’t happen.”